During their recent episode, Taylor, Carlisle, and Alex Edmans discussed How to Spot a Stock Market Bubble Before It Bursts. Here’s an excerpt from the episode:
[Alex] So that’s a good starting point because my book is a counterpoint to that. But again, lets me stand in the corner of the other side. So the idea of the wisdom of the crowds is that when you look at, say, the market, you’re learning from the opinions of thousands or millions of people and you’re getting their collective knowledge.
So there was a book called The Wisdom of Crowds by James Turowicki, which was very influential. And it starts off with the example of people trying to guess the ox county fair. And the pundits who showed up were random people.
They were farmers. They had no expertise in getting the weight of an ox. And they would make huge mistakes.
But as we discussed earlier, if we make mistakes in opposite directions, they will cancel out. And what was found was the average guess was actually very close to the weight of the actual ox. I think this applies to financial markets because of emotions and sentiment.
Nobody gets emotionally attached to the weight of an ox. Nobody has opinions about that. People do get overly attached to narratives and stories such as vehicles will be the future or cryptocurrency is the democratisation of finance and we’re not enslaved to central banks anymore.
Or it will be that AI is going to be the future and it’s going to be transformative. And when we see this narrative, then we see lots of people acting in the same direction. Then your mission is, well, when do we know that the crowd has switched from wise to mad?
You might want to then start looking at fundamentals. And so that is the opposite. That’s the anchor to emotions.
And what are fundamentals? Well, this is what a business is truly worth, something price to earnings ratio, how much you’re paying for stock relative to the earnings that it generates. And so if we go to Cisco in 2000, as I mentioned, its price earnings ratio was 190.
Now, people might have thought, well, isn’t that justified because of the tech bubble? But Microsoft’s price earnings multiple was a third of that. And Intel’s was a quarter of that.
So here it was having a massive no speed valuation, which was towering above its tech rivals. And also to think about, well, what is engendered into that valuation? Cisco’s price earnings multiple was justified if it could grow five times, within the six times, sorry, within the next five years.
And then it did grow six times, but it took 25 years to get there. So often the market gets the direction right. Yes, the internet was the future, but the speed wrong.
They just overestimated the extent to where elderly people would want to do online banking, branch banking. One might say the same was the true in the EV bubble in the early 2020s, where people know that EVs will be the future, but maybe the adoption will be slow because we don’t yet have good battery storage or charging infrastructure. And so when we are trying to compare things to actual fundamentals, what are the profits that the companies make?
Or in the EV case, compare the value of the entire EV industry to the traditional car industry. And back in 2020, the EV industry was worth more than the traditional car industry, even though it was making a fraction of the revenue. There are benchmarks that we can look at to see whether the valuation is actually justified.
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